Oil sands producers could feel squeeze in crowded market

Alberta’s oil sands producers have some very ambitious output forecasts that could see them producing about a sixth of what OPEC now pumps out on a daily basis by the end of the decade.

But there are some potentially nasty roadblocks that could force the Canadian producers to slash millions of barrels per day from those targets, not the least of which is transportation.

“Oil sands companies that are making big capital allocation decisions have to be that much more confident in the macro environment to hit the button,” Andrew Potter, managing director, institutional equity research at CIBC World Markets Inc., told the Financial Post.

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But confidence is in short supply as events appear to have conspired against Canadian producers. The higher-cost oil sands have to compete with U.S. and Canadian tight oil for pipeline access. In addition, the dreaded double discount on Canadian crude compared to oil produced elsewhere has restrained profits and new pipeline plans are being put in question by environmentalist opposition and warring provinces.

“In a market that is oversaturated, there will no doubt be rationalization and the first projects to get squeezed will be those with higher supply costs and a riskier capital profile,” wrote Mr. Potter in a note to clients. “Unfortunately, higher cost oil sands projects seem like the first to get rationalized.”

Production estimates vary. In its more conservative outlook, the Canadian Association of Petroleum Producers (CAPP) forecasts oil sands production will rise by 180,000 barrels per day each year to reach a total of 3.2 million bpd in 2020. The companies themselves have a more generous collective estimate of a 380,000 bpd rise every year to hit five million bpd. CIBC believes a more likely production growth estimate would be growth of 270,00 bpd per year.

All of that assumes an array of planned pipelines don’t bog down in regulatory quagmires — which is crucial as Canadian bitumen, tight oil and Bakken crude jostle for increasingly scarce pipeline access.

“Even if Keystone XL, TransMountain, Northern Gateway and the tentative TransCanada West Coast Line were all built, there would still not be enough pipeline capacity to handle planned growth through 2020.”

CIBC estimates suggest that producers will have to scale back production forecast anywhere between 1.7-million bpd and 2.4-million bpd if market access is restricted.

The Western Canada Select discount to West Texas Intermediate is another issue hurting the prospects of Canadian oil sands. While low-cost SAG-D producers can operate in a $43 per oil barrel environment, those involved in upgraded mining will need $83.30 per barrel to breakeven, assuming a 15% discount to WTI. Which means if oil prices fall to $70 per barrel, close to a million barrels per day of planned production would not justify proceeding, CIBC estimates.

There is much uncertainty for oil sands surrounding costs, concurs Carmen Velasquez, associate director of global oil at IHS CERA. “One of the things we have learned from the last cycle in 2008, was we experienced labour shortages and had to bring in foreign workers and we saw cost escalation. But at that time, cost escalation was higher than this time around, and I feel we are being proactive [this time]. When I talk to construction contractors, a lot of them are bringing in foreign workers.”

IHS estimates Canada will need at least 12,000 foreign workers to meet rising demand by 2014-2015, which could further add to producers’ costs.

The oil price environment doesn’t inspire confidence either. The International Energy Agency recently trimmed its demand forecast by 400,000 bpd in 2013 due to a worrying slowdown in the global economy, although oil prices remain elevated due to Middle East unrest and massive stockpiling by Asian countries.

And analysts expect crude prices to fare far worse if the Israel-Iran conflict is taken out of the equation. Some companies are already paying heed to the changing landscape. Canadian Natural Resources cut its capital expenditure by 10%, or $700-million by 2012, while Suncor is reviewing its $1.75-billion joint venture deal with France’s Total E&P.

“In principle, there is the opportunity to not progress those projects,” said Suncor chief Steve Williams during a teleconference with analysts on July 25. “It is possible to withdraw.”

Such headwinds also make the oil sands a less attractive target for investors. “There has been a cooling off period in M&As, no question about it, and it will continue to cool,” Mr. Potter said, adding that the days of record-setting deals may not be in the cards. “With record-low cost of capital and low valuations, there is room for transactions — we have seen that with Progress and Nexen. Conditions are ripe for M&A, but not exclusive to oilsands.”

Still, there is hope. Most analysts, including Mr. Potter, believe Keystone XL will get built. In addition, TransCanada’s proposal to convert one of its gas pipelines to carry oil to Eastern Canada could add 650,000 bpd to capacity.

And while oil sands production remains capital-intensive and expensive, Canadian tight oil has surprised on the upside. Canadian light oil production was up 35,000 bpd in 2011 compared to the prior year as tight oil offset flat conventional light oil output. Figures for the first four months of 2012 suggest production is already 70,000 bpd higher than last year. CIBC expects light oil production to rise 100,000 bpd till 2016, compared to CAPP’s 40,000 bpd forecast. But the rise of tight oil means that oil sands suffer from greater company and public scrutiny.

“No company voluntarily gives up the quest for growth… but some will have to,” Mr. Potter noted.